Medtronic Earnings Preview: Cost Cutting Efforts In Focus

Medical device maker Medtronic, Inc. (NYSE: MDT) reported year-over-year (y-o-y) operational sales growth of over 4% in the third quarter of fiscal 2014 to about $4.2 billion, driven by steady growth across all its divisions. Its largest divisions, Cardiac Rhythm Disease Management and Cardiovascular, continued to grow in the low single digits while its other divisions such as Neuromodulation, Surgical Technologies and Diabetes also registered solid growth. Gross margins improved by 80 basis points sequentially to 74.8% as cost-saving efforts under its five-year $1.2 billion cost reduction plan bore fruit.

When Medtronic comes out with its Q4 earnings on May 20, we expect operational sales growth to meet the company’s guidance of 3-4%. Most of the company’s major businesses are likely to sustain their growth momentum as new products have found good acceptance. We also expect gross margins to remain stable near 75% as Medtronic’s cost saving efforts offset growing pricing pressures and product quality issues in some divisions.

CRDM is Medtronic’s largest division, accounting for about 30% of total sales. Primarily consisting of pacemakers and defibrillators, the CRDM division reported sales growth of a modest 2% y-o-y in the last quarter driven by over 20% growth in the Atrial Fibrillation business and 1% operational growth in implantable cardioverter defibrillator sales.

Following weak demand in early FY14, ICD sales have recently improved because of growing acceptance of the company’s new products, such as Evera ICD, Viva XT CRTD (ICD with pacing capabilities) and Attain Performa Quadripolar leads. While Medtronic lost some share in the U.S. market owing to overall weak demand and increasing competition, robust sales of Viva XT CRTD and APQ leads in Europe and Japan helped the company add 50 basis points to its international market share in the last quarter. Going forward, we expect the company to continue to add share in international markets, which should help it improve its global CRDM market share as well.

Expect Slow Revenue Growth In Cardiovascular

Cardiovascular consists of the Coronary, Structural Heart and Endovascular businesses, which offer products such as stents, heart valves and renal denervation systems for treating hypertension. The overall business reported operational sales growth of about 1% y-o-y to $935 million in the fiscal third quarter. Sales of drug-eluting stents increased 5% on an operational basis driven by strong global sales of the company’s Resolute DES.

Although Endovascular sales increased by 4% y-o-y, they were negatively impacted by discontinuation of below-the-knee drug-eluting balloon program and divestment of re-entry catheter products. Renal denervation also suffered a setback last quarter when the company declared that its Symplicity HTN-3 trial in the U.S. had been unsuccessful. In the upcoming earnings, we expect continued strong sales of the Resolute DES to offset potential losses due to the discontinued drug-eluting balloon program and the unsuccessful renal denervation trial.

Medtronic’s CoreValve Transcatheter Aortic Valve systems, part of the Structural Heart business, saw strong sales in international markets in Q2 and Q3. The company received earlier-than-expected FDA approval to sell its CoreValve system in the U.S. in the later half of the third quarter, which should help the company’s sales in Q4. However, CoreValve’s near-term prospects in the U.S. look due to Medtronic’s legal dispute with rival medical device maker Edwards Lifesciences over the CoreValve device (see Medtronic Gets Relief In Edwards Patent Case, But Near-Term U.S. Outlook For CoreValve Looks Grim).

While we expect Cardiovascular sales to grow due to strong international performance and seasonality factors, its y-o-y growth is likely to be slower due to a tough comparable period. In terms of Medtronic’s share in the global Cardiovascular market, we expect it to remain stable around 25-26% as gains in the international market are likely to be offset by sluggishness in the U.S.

Gross Margins Likely To Remain Stable

Gross margins improved 80 basis points sequentially in the third quarter to 74.8% as the company successfully dealt with the accumulated obsolete inventory and higher write-offs that impacted margins in Q2. However, gross margins were negatively impacted by costs incurred in resolving quality issues in the Neuromodulation and Diabetes segments. Although quality-improvement expenses are expected to continue in the near future, we expect the company to achieve its target of 75% operational gross margins in Q4 owing to its persistent cost-reduction efforts.

Medtronic’s research and development (R&D) costs have typically ranged between 9% and 9.5% of its revenues over the past several years. Its R&D costs as a percentage of revenue were 8.6% in the third quarter fiscal 2014 owing to improvements in organizational productivity and the shift of R&D centers to new regions such as China and India. We expect R&D costs as a percentage of sales to come down to close to 8% in Q4, owing to its characteristic fourth quarter leverage, the shifting of R&D centers and trade-offs by the company to reduce its medical-device tax liabilities in the U.S. If Medtronic stabilizes its R&D costs to around this level in the medium to long term, there could be a potential upside of about 3% to our price estimate for the company.

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